Knowledge that Transforms

In November of 2007 a fire sale of Chilean stocks was triggered by a change in the constraints that regulate pension fund portfolios. This regulatory shock provided a cleanly identified fire sale unrelated to fundamentals. Stocks with more selling pressure from pension funds lost approximately 4% in November compared to other stocks. Although the selling pressure was temporary, prices reverted only after four to six months. Pension funds initially mitigated the impact of the fire sale by selling large index stocks in which demanding liquidity was less costly. Coordination across pension funds increased during the fire sale. We find no significant evidence of real effects on firm investment in the quarters after the fire sale.

Regulatory changes in the over-the-counter (OTC) derivatives market seek to reduce systemic risk. The reforms require that standardized derivatives be cleared through central counterparties (CCPs), and they set higher capital and margin requirements for non-centrally cleared derivatives. We investigate whether these requirements create a cost incentive in favor of central clearing, as intended. We compare the total capital and collateral costs when banks transact fully bilaterally and when they clear all contracts through CCPs. We calibrate our model using data on the OTC market collected by the Federal Reserve. We find that the cost incentive may not favor central clearing. The main factors driving the cost comparison are netting benefits, the margin period of risk, and CCP guarantee fund requirements. Lower guarantee fund requirements lower the cost of clearing but make CCPs less resilient.

We study how lenders in blockheld firms exploit the information on the other holdings of equity blockholders to learn their attitude toward creditors. In the presence of the conflict of interest between lenders and equityholders, information on how blockholders behave in the other firms they control provides the lenders with key information about potential blockholder behavior. We test this hypothesis using data on US public firms over the 2001–2008 period. We show that the financial conditions of these co-owned firms affect how lenders value other firms in which the owner has a major stake. Bad news on credit quality in co-owned firms raise the firm's credit risk. Our identification is based on the instrumental variables estimation where we instrument the changes in credit risk of co-owned firms by the natural disaster events in the counties of co-owned firm headquarters.

We examine the hypothesis that fluctuations in the aggregate supply of bank loans influence the supply of new equity capital. Using residual lending standards as a clean measure of aggregate loan supply and a VAR framework to aid identification, we find that a one-standard-deviation shock to lending standards results in 15% fewer IPOs. Shocks elicit strong responses from IPO-firms that are highly dependent on external capital and increase the number of withdrawals, strengthening the interpretation that the above is driven by changes in the supply of equity. Our results suggest that credit conditions are important to a well-functioning IPO market.

This paper empirically characterizes relationship lending using data from more than 20,000 loans of a Spanish bank to small and medium enterprises (SMEs). The study analyzes the pricing determinants of loans to firms based on the entire previous bank–firm relationship, allowing for the identification of nonlinear pricing patterns in the bank–firm relationship. We show that firms only start capitalizing the gains of relationship lending when the relationship extends beyond two years. This reduction in the loan rate spread charged is driven by the opaque firms, for which the acquisition of “soft” information is especially relevant. Finally, we find that relationship lending significantly mitigates the increased costs of refinancing loans along two dimensions: relationship duration and having additional contracts—other than loans—with the bank.

We construct a measure of a bank's relative creditworthiness from the Eurosystem's proprietary inter-bank loan data: average overnight borrowing rate relative to an overnight rate index (AOR). We then investigate the dynamic relationship between AOR and the credit default swap price relative to the corresponding market index of 60 banks during 2008–2013. Price discovery mainly takes place in the CDS market, but AOR also contributes to it. The lagged daily changes of AOR help predict CDS. This indicates that AOR includes private information, which the CDS market does not immediately incorporate. We further show that the private information advantage is concentrated on days of market stress and on banks, which mainly borrow from relationship lender banks. Such borrower banks are typically smaller, have weaker ratings, and are likely to reside in crisis countries. Competent authorities can use AOR as a complementary indicator of banks’ concurrent health.

The high-tech sector accounts for the majority of corporate innovation in modern economies. In a sample of 38 countries, we document a strong positive relation between the initial size of the country's high-tech sector and subsequent rates of GDP and total factor productivity growth. We also find a strong positive connection between a country's equity (but not credit) market development and the size of its high-tech sector. Our main difference-in-differences estimates show that better developed stock markets support faster growth of innovative-intensive, high-tech industries. The main channels for this effect are higher rates of productivity and faster growth in the number of new high-tech firms. Credit market development fosters growth in industries that rely on external finance for physical capital accumulation but is unimportant for growth in innovation-intensive industries. These findings show that stock markets and credit markets play important but distinct roles in supporting economic growth. Stock markets are uniquely suited for financing technology-led growth, a particularly important concern for advanced economies.

This paper tests whether an increase in insured deposits causes banks to become more risky. We use variation introduced by the U.S. Emergency Economic Stabilization Act in October 2008, which increased the deposit insurance coverage from 100,000 to 250,000 per depositor and bank. For some banks, the amount of insured deposits increased significantly; for others, it was a minor change. Our analysis shows that the more affected banks increase their investments in risky commercial real estate loans and become more risky relative to unaffected banks following the change. This effect is most distinct for affected banks that are low capitalized.

We explore the trading decisions of equity mutual funds during ten periods of extreme market uncertainty. We find that mutual funds reduced their aggregate holdings of illiquid stocks. Exploring the drivers behind this result reveals that this is mainly driven by larger withdrawals from funds that hold less liquid stocks. We further find that the sell-off of illiquid stocks occurred only after initial deterioration in market conditions, consistent with retail investors’ response to bad performance. At a broader level, this shows that mutual funds consumed liquidity during periods where liquidity was most valuable. Moreover, the fact that fund managers traded in response to these withdrawals suggests a potentially magnifying channel for the drop in illiquid stock prices, also known as flight-to-liquidity.

This paper examines the association between the default risk of foreign bank subsidiaries in developing countries and their parents during the global financial crisis, with the purpose of determining the size and sign of this correlation and, more importantly, understanding what factors can help insulate affiliates from their parents. We find evidence of a significant and robust positive correlation between parent banks’ and foreign subsidiaries’ default risk. This correlation is lower for subsidiaries that have a higher share of retail deposit funding and that are more independently managed from their parents. Host country bank regulations are also associated with the extent to which shocks to the parents affect the subsidiaries’ default risk. In particular, the correlation between the default risk of subsidiaries and their parents is lower for subsidiaries operating in countries that impose higher capital, reserve, provisioning, and disclosure requirements, and tougher restrictions on bank activities.